Mortgage Modifications in Bankruptcy Would Undermine Homeownership, Prevent Few Foreclosures

Federal housing policy, we now know, has caused catastrophic
economic failures. Programs designed to expand homeownership did so
at the expense of sound lending and borrowing, to the ultimate
detriment of economic stability and many families' finances.

But one federal housing policy worked to reduce the price of
housing credit and to extend its availability without
contributing to the mortgage mess: denying bankruptcy judges
the power to modify home mortgages, a practice known as
"strip-down" or "cram-down." This added certainty allowed lenders
to accept smaller down payments and offer lower interest rates
to millions of American homeowners without providing any incentive
to make irresponsible loans.

Now Congress is considering snuffing out this one bright spot by
giving judges the power to discharge mortgage debt in bankruptcy
and rewrite repayment terms. If enacted, these proposals would
increase the cost of homeownership and put it out of reach for many
Americans, especially those of lesser means. They would also deal a
blow to banks and other lenders at a time when many are
faltering, thereby undermining government efforts to increase
stability in that sector. Worst of all, allowing bankruptcy judges
to rewrite mortgages would prevent few foreclosures while causing
harm to those it is intended to protect.

Fundamentally, strip-down is a poor "fit" for the problem of
rising foreclosure rates. Its benefits would fall
disproportionately to those who can afford their mortgage payments
and do not need relief, while those whose homes are at risk would
typically obtain only temporary relief at a great personal cost.
The result would be to impose enormous expenses on mortgage and
consumer lenders-at a time when doing so would be destabilizing and
counterproductive-in exchange for extremely limited benefits
for vulnerable homeowners.

Congress should look beyond the following myths about mortgage
strip-down and recognize that its costs, in the form of unintended
consequences, would far outweigh its limited benefits.

Myth: Current law
provides no relief from foreclosure for primary
residences.

Reality: Under Chapter 13 of the
Bankruptcy Code, individuals can stop foreclosure proceedings
and spread delinquent payments over a period of time, and most
mortgage servicers are willing and able to renegotiate loans when
mutually beneficial.

The current Bankruptcy Code carefully balances the need for
predictability and stability in mortgage lending with the needs of
borrowers who have temporarily fallen behind on their
payments. Unlike a Chapter 7 liquidation, in which most of an
individual's assets are sold to pay his or her debts, a
Chapter 13 bankruptcy puts an immediate halt (known as the
"automatic stay") to foreclosure proceedings from the moment of
filing and then gives the individual an opportunity to catch
up on late payments.

Specifically, instead of being forced to bring a mortgage up to
date all at once, a borrower suffering a temporary financial
setback can spread the burden over a period of up to three to five
years, depending on his or her income and expenses. During this
period, the borrower must also continue to make regular scheduled
mortgage payments. Once the deficiency has been made up, the
payment schedule continues pursuant to the terms of the mortgage
until the house is paid off or sold.

Moreover, homeowners can obtain relief by renegotiating the
terms of their mortgages with those who hold or service them. When
the alternative is a foreclosure valued at far less than the
principle remaining in the loan, both homeowners and mortgage
investors benefit by modifying the loan to reduce the principle and
ease the terms of repayment. This standard is the same that
bankruptcy courts would apply under mortgage strip-down proposals
but is applied in a way that avoids the blunt, one-size-fits-all
approach of strip-downs. Though some mortgages have been privately
securitized in ways that present barriers to
renegotiation, the vast majority are not subject to such
limitations.

The current Chapter 13 process, as well as voluntary and
mutually beneficial relief provided by mortgage servicers, serves
to separate borrowers whose income is likely to be sufficient to
make payments that exceed the foreclosure values of their home
from those who have borrowed beyond their means and lack the
earning capacity to afford the home that they nominally own but in
which (usually) they have little equity. Granting judges new
power to modify mortgage terms would blur this line, encouraging
both those who have taken on excessive debt and those who have
borrowed reasonably and need no relief to reject voluntary
renegotiation and seek better terms in bankruptcy.

Myth: Allowing
strip-down will not increase the cost or reduce the availability of
mortgage loans.

Reality: If forced to shoulder greater
risk and expense, mortgage lenders will demand higher interest
rates and bigger down payments, putting homeownership out of
reach for many low- and middle-income Americans.

Congress cannot repeal the laws of economics. Thus, it is
unreasonable to expect that lenders would not adjust their up-front
terms in response to changes in the law that weakened loan
enforcement. Experience and research show that any
proposal that has the effect of undermining the certainty of
mortgage agreements or imposing losses on mortgage lenders will
serve to reduce the availability and increase the cost of mortgage
loans.

Strip-down proposals would impose massive and unjustifiable
costs on lenders. Despite the current state of the economy,
less than 5 percent of homeowners are more than 60 days behind on
their mortgages-the usual measure of delinquency. Yet strip-down
would be available as well to the more than 50 million homeowners
who are current on their mortgages if they filed bankruptcy. If
even a small percentage of these homeowners chose to take advantage
of bankruptcy to discharge some of their mortgage debt, their
numbers, as well as the total value of the debt they would
discharge, would far exceed the number of those in dire straits
obtaining strip-downs. Thus, hundreds of billions in debts that
likely would have been paid would be relieved.

These costs, in turn, would be reflected in the availability and
price of mortgages. To protect themselves from future
strip-downs, lenders would have to demand increased down payments
from mortgage borrowers. Requiring that borrowers put down
enough money to cover any foreseeable decline in the value of their
homes is the only way to avoid the risk of a future strip-down.

Home price volatility provides some indication of the magnitude
of the down payments that would be required. Over the past year,
U.S. home prices have declined by about 12 percent, with some
regions seeing drops as high as 30 percent, and prices are still
falling. Under current law, down payments are typically 10
percent to 20 percent of the price of a home, but this amount would
be insufficient to protect lenders in a volatile market. If
the risk of strip-downs led to down payments of 20 percent to
30 percent, a down payment on the median house, valued at just over
$200,000, would be $40,000 to $60,000-far more than many families
could scrape together. Hardest hit would be first-time home buyers,
who cannot draw upon existing home equity, and lower- and
middle-class families.

Additionally, lenders would demand higher interest rates and
fees as compensation for taking on the added risk of losing money
if the loan is stripped down. Because strip-down is such a blunt
and indiscriminate tool, all borrowers, no matter their
creditworthiness, would face higher rates on mortgages. The
biggest increases, though, would fall on first-time home buyers and
lower-income families, as lenders demand larger risk premiums.

Recent research confirms this effect. In one study, Karen Pence,
a senior economist at the Federal Reserve Board who studies
household and real estate finance, determined that state laws that
impose costs on lenders (as much as 10 percent of the value of the
loan balance) prior to foreclosure reduce the availability of
credit for residents of those states. As a result of these laws,
families "may pay more for their mortgages, purchase smaller
houses, or have difficulty becoming homeowners." If strip-downs
impose larger costs on lenders, they would likely have an even
greater effect on interest rates and mortgage availability.[1]

Similarly, economists Emily Lin and Michelle White found that
unlimited homestead exemptions, which allow individuals to shelter
home equity from creditors in bankruptcy, significantly reduce the
availability of mortgages and home-improvement loans.[2]

The result, then, of allowing the discharge of home mortgage
debt in bankruptcy would be to put home lending out of reach of
many Americans and to raise the cost of borrowing for those who are
able to secure mortgages, further weakening the housing market.
This is a perverse result, considering that the long-standing aim
of U.S. housing policy has been to encourage homeownership by
promoting affordability in the mortgage market.

That some proposals are temporary in nature would not prevent
this outcome, because mortgage lenders (as well as borrowers) would
reasonably expect Congress to reinstate strip-downs in the next
economic crisis. Indeed, a repeat of this policy would be even more
likely once the precedent is set and lenders' and borrowers'
expectations are altered.

Reality: Instead of changing loan
terms, courts regularly require the liquidation of luxury and
"lifestyle" assets to increase distributions to other
creditors.

Proponents of strip-down proposals make much of the fact that
Chapter 13 allows for the modification of most debts other
than those secured by a primary residence. Current law, notes
Representative John Conyers (D-MI), who has sponsored
legislation that would permit strip-downs, permits
judicial modification of "loans secured by second homes,
investment properties, luxury yachts, and jets" but not primary
residences.[3]

In reality, luxury and "lifestyle" assets are rarely afforded
this treatment because they are not considered to be necessary
to the support of the filer or his family. Though a filer may
propose a plan that modifies claims secured by luxury items,
bankruptcy judges have extremely broad discretion to reject such
modifications when they impair the rights of other creditors.

Further, unlike mortgage strip-down proposals, current law
requires the filer to pay off in full any secured claim that is
modified, including any arrearages, during the duration of the plan
within just three to five years. For example, a debtor who manages
to strip down a $300,000 mortgage on a vacation home to $200,000
would have to make equal monthly installments over the course of
just a few years to retire that debt.

Thus, in most cases, luxury and "lifestyle" items- things like
vacation homes and yachts-that are encumbered by debt are
surrendered to the creditor and liquidated to pay off the debt and,
in many instances, obtain funds that can be used to pay other
creditors. The debts encumbering them are not stripped down. And in
the rare cases where this does not occur and the debt is stripped
down, the filer is required to pay off the remaining secured
portion of the debt, including arrearages at the time of
filing and any penalties and fees, over the course of the Chapter
13 plan and may also have to pay off a portion of the remainder of
the loan-that is, the part that was crammed down-which remains as
an unsecured debt.

Myth: Allowing
strip-downs will help consumers.

Reality: Encouraging more families to
file for bankruptcy will undermine more promising means of
refinancing mortgage debt, hurt consumer credit, and ultimately
prevent few foreclosures.

Filing for Chapter 13 bankruptcy is an expensive and disruptive
process. While the total fees for filing are only about $300,
guideline attorney's fees range from about $2,500 to $5,000 in
simple cases, depending on the district; in complex cases, the fee
can be much higher. Indeed, the difficulty of stripping down a
home mortgage could be expected to increase fees by several
thousand dollars.

In addition, filings are included on credit reports immediately
upon filing and remain there for seven years. Thus, Chapter 13
bankruptcy damages credit scores and impairs access to credit for a
significant period of time.

Many Chapter 13 bankruptcies fail; that is, the filer never
obtains a discharge of his debts. Nearly 20 percent of Chapter 13
cases fail before the court has confirmed the filer's plan. Another
55 percent fail between confirmation and discharge because the
filer has been unable to carry out his plan. This means that only
one-third of all Chapter 13 filers complete the process
successfully and get the fresh start that bankruptcy promises. The
rest-two-thirds of all filers-pay court fees, pay attorney's fees,
pay fees to the bankruptcy trustee, invest time and money to
restructure their financial affairs, and then wind up with nothing
more than temporary relief. It is therefore not surprising that a
substantial number of Chapter 13 filers-nearly one-third-go on to
file for bankruptcy again.[4]

These statistics suggest that holding out the promise of
significant relief from mortgage debt to encourage more individuals
to file for Chapter 13 bankruptcy is bad policy. At best, Chapter
13 would serve only to delay foreclosures in most case where the
home is at risk while imposing enormous costs on those who are
already financially vulnerable and losing their access to
credit.

Worse, allowing discharge of home mortgage debt in bankruptcy
would undermine more promising approaches to preventing
foreclosures. While there have been difficulties in renegotiating
certain types of securitized mortgages, the bulk of
outstanding mortgages are controlled or owned by Fannie Mae
and Freddie Mac, private banks, and portfolio lenders, all of which
have the power to renegotiate mortgages and face strong incentives
to do so to preserve the value of homes.

Strip-downs, however, would undermine their efforts by
eliminating homeowners' incentives to accept modification offers,
even ones that are targeted to their situation and less
disruptive than bankruptcy is likely to be. In this way, strip-down
proposals would only delay foreclosures while blocking more
promising alternatives that protect consumers' financial
security.

Myth: Allowing
strip-downs will help the economy.

Reality: Undermining the certainty of
loan agreements threatens the availability of credit, and thereby
market stability, and will only delay recovery, especially in the
housing sector.

Some claim that allowing strip-downs in bankruptcy would
ease turmoil in the housing markets and slow or reverse declines in
home prices. This is a pipe dream.

Merely allowing strip-downs in bankruptcy could be enough to
trigger bank instability and failures. U.S. banks and thrifts
hold about $315 billion worth of highly rated mortgage-backed
securities that would suffer immediate and permanent
downgrades. This, in turn, would force banks to write down
these assets to reflect their lower value and set aside additional
capital to satisfy regulatory requirements. Some banks'
already overburdened balance sheets could not absorb those
hits.

And as described above, allowing strip-downs could push millions
of Americans, who are current on their mortgages and whose homes
are not at risk of foreclosure, into bankruptcy. Any reductions in
loan principle that they achieved would come at the expense of
lenders, increasing the likelihood of their insolvency and further
tightening credit markets. Resulting declines in the valuations of
mortgage-backed securities and other "troubled assets" could also
affect banks' capital statements, leading to more failures and the
need for additional capital on top of that already being provided
by the federal government. Some of these losses would fall to
taxpayers through Fannie Mae and Freddie Mac (which guarantee
over $5 trillion in mortgage debt), other government entities,
and recent government investments in the financial sector. The
drawn-out bankruptcy process would also put a brake on efforts to
value mortgage-backed securities and begin to clean up banks'
balance sheets, thereby prolonging current financial
instability.

Further, increases in bankruptcy filings would harm the
financial health of many additional industries. In Chapter 13,
unsecured creditors (those whose loans are not backed by property
that can be repossessed or foreclosed) typically receive less than
20 percent of what they are owed. Facing this risk, lenders would
further tighten the availability of credit, dealing a new blow to
the demand side of the economy. This result would be perfectly
opposed to Congress's current efforts to stimulate consumer
demand.

Conclusion

It should not be surprising that there is no free lunch.
Congress cannot enact a policy that imposes major, unexpected
losses on home lenders without raising the cost of and reducing
access to home loans. Claims to the contrary are unsupported either
by experience or by the available data.

What is a surprise, though, is the minuscule benefit that
such a policy would achieve. Allowing the strip-down of home
mortgage debt in bankruptcy would prevent very few foreclosures
even as it undermined better alternatives for homeowners.

That this policy would have any positive effect at all is
premised on wishful thinking: that Chapter 13's deliberately weak
protections for debtor assets, which are ultimately unavailing in
the majority of cases, will do anything more than delay some
foreclosures at an enormous cost to the economy. At the same
time, this policy would open the door to achieving mortgage
reductions for tens of millions of homeowners who can afford their
mortgage payments and whose homes are not at risk.

The growing but still relatively small foreclosure rate may
warrant a policy response, but Congress must take care not to rush
into ill-conceived fixes that threaten to cause more harm than they
would alleviate. To avoid that risk, proposals must be
carefully targeted and proportionate to the problems they are
intended to address.

Opening the door to modification of all home mortgages is
both overbroad and extreme and, for that reason, risky. Rather than
risk adding to the turmoil in the housing and financial markets,
Congress should consider approaches that do not undermine
investors' expectations and, ultimately, homeownership.

Andrew M. Grossman is
Senior Legal Policy Analyst in the Center for Legal and
Judicial Studies at The Heritage Foundation.

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Allowing judges to discharge mortgage debt in bankruptcy andrewrite repayment terms would put homeownership out of reach formany Americans, especially those of lesser means; deal a blow tobanks and other lenders at a time when many are faltering, therebyundermining government efforts to increase stability in thatsector; and prevent few foreclosures while harming those it isintended to protect.

Key Points

1 Allowing judges to modify the amount and
terms of mortgages—known as “strip-down”—
would put homeownership out of reach for
many Americans.

2 To protect against the risk of strip-down,
mortgage lenders would have to raise interest
rates on loans and demand bigger down
payments—as much as $40,000 to $60,000
for the median home. First-time buyers, who
cannot draw upon existing home equity, and
lower- and middle-class families would bear
the brunt of these responses.

3 Judge-imposed strip-downs would prevent
few foreclosures. Two-thirds of Chapter 13 filings
fail, with the filer receiving no relief from
debt. In most cases, strip-down would only
delay foreclosure at enormous expense to
the homeowner in legal fees and damaged
credit.

4 Strip-down’s benefits would fall disproportionately
to those who can afford their mortgage
payments and do not need relief,
threatening the availability of credit and stability
of lenders.

Key Points

Allowing judges to modify the amount and
terms of mortgages—known as “strip-down”—
would put homeownership out of reach for
many Americans.

To protect against the risk of strip-down,
mortgage lenders would have to raise interest
rates on loans and demand bigger down
payments—as much as $40,000 to $60,000
for the median home. First-time buyers, who
cannot draw upon existing home equity, and
lower- and middle-class families would bear
the brunt of these responses.

Judge-imposed strip-downs would prevent
few foreclosures. Two-thirds of Chapter 13 filings
fail, with the filer receiving no relief from
debt. In most cases, strip-down would only
delay foreclosure at enormous expense to
the homeowner in legal fees and damaged
credit.

Strip-down’s benefits would fall disproportionately
to those who can afford their mortgage
payments and do not need relief,
threatening the availability of credit and stability
of lenders.

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